Public Goods and Externalities

[An updated version of this article can be found at Public Goods in the 2nd edition.]

Most economic arguments for government intervention are based on the idea that the marketplace cannot provide public goods or handle externalities. Public health and welfare programs, education, roads, research and development, national and domestic security, and a clean environment all have been labeled public goods.

Public goods have two distinct aspects—"nonexcludability" and "nonrivalrous consumption." Nonexcludability means that nonpayers cannot be excluded from the benefits of the good or service. If an entrepreneur stages a fireworks show, for example, people can watch the show from their windows or backyards. Because the entrepreneur cannot charge a fee for consumption, the fireworks show may go unproduced, even if demand for the show is strong.

The fireworks example illustrates the "free-rider" problem. Even if the fireworks show is worth ten dollars to each person, no one will pay ten dollars to the entrepreneur. Each person will seek to "free-ride" by allowing others to pay for the show, and then watch for free from his or her backyard. If the free-rider problem cannot be solved, valuable goods and services, ones that people want and otherwise would be willing to pay for, will remain unproduced.

The second aspect of public goods is what economists call nonrivalrous consumption. Assume the entrepreneur manages to exclude noncontributors from watching the show (perhaps one can see the show only from a private field). A price will be charged for entrance to the field, and people who are unwilling to pay this price will be excluded. If the field is large enough, however, exclusion is inefficient because even nonpayers could watch the show without increasing the show's cost or diminishing anyone else's enjoyment. That is nonrivalrous competition to watch the show.

Externalities occur when one person's actions affect another person's well-being and the relevant costs and benefits are not reflected in market prices. A positive externality arises when my neighbors benefit from my cleaning up my yard. If I cannot charge them for these benefits, I will not clean the yard as often as they would like. (Note that the free-rider problem and positive externalities are two sides of the same coin.) A negative externality arises when one person's actions harm another. When polluting, factory owners may not consider the costs that pollution imposes on others. Policy debates usually focus on free-rider and externalities problems, which are considered more serious problems than nonrivalrous consumption.

While most people are unaware of it, markets often solve public goods and externalities problems in a variety of ways. Businesses frequently solve free-rider problems by developing means of excluding nonpayers from enjoying the benefits of a good or service. Cable television services, for instance, scramble their transmissions so that nonsubscribers cannot receive broadcasts. Both throughout history and today, private roads have financed themselves by charging tolls to road users. Other supposed public goods, such as protection and fire services, are frequently sold through the private sector on a fee basis.

Public goods can also be provided by being tied to purchases of private goods. Shopping malls, for instance, provide shoppers with a variety of services that are traditionally considered public goods: lighting, protection services, benches, and rest-rooms, for example. Charging directly for each of these services would be impractical. Therefore, the shopping mall finances the services through receipts from the sale of private goods in the mall. The public and private goods are "tied" together. Private condominiums and retirement communities also are examples of market institutions that tie public goods to private services. Monthly membership dues are used to provide a variety of public services.

Lighthouses are one of the most famous examples that economists give of public goods that cannot be privately provided. Economists have argued that if private lighthouse owners attempted to charge ship-owners for lighthouse services, a free-rider problem would result. Yet lighthouses off the coast of nineteenth-century England were privately owned. Lighthouse owners realized that they could not charge shipowners for their services. So they didn't try to. Instead, they sold their service to the owners and merchants of the nearby port. Port merchants who did not pay the lighthouse owners to turn on the lights had trouble attracting ships to their port. As it turns out, one of the economics instructors' most commonly used examples of a public good that cannot be privately provided is not a good example at all.

Other public goods problems can be solved by defining individual property rights in the appropriate economic resource. Cleaning up a polluted lake, for instance, involves a free-rider problem if no one owns the lake. The benefits of a clean lake are enjoyed by many people, and no one can be charged for these benefits. Once there is an owner, however, that person can charge higher prices to fishermen, boaters, recreational users, and others who benefit from the lake. Privately owned bodies of water are common in the British Isles, where, not surprisingly, lake owners maintain quality.

Well-defined property rights can solve public goods problems in other environmental areas, such as land use and species preservation. The buffalo neared extinction and the cow did not because cows could be privately owned and husbanded for profit. Today, private property rights in elephants, whales, and other species could solve the tragedy of their near extinction. In Africa, for instance, elephant populations are growing in Zimbabwe, Malawi, Namibia, and Botswana, all of which allow commercial harvesting of elephants. Since 1979 Zimbabwe's elephant population rose from 30,000 to almost 70,000 today, and Botswana's went from 20,000 to 68,000. On the other hand, in countries that ban elephant hunting—Kenya, Tanzania, and Uganda, for example—there is little incentive to breed elephants but great incentive to poach them. In those countries elephants are disappearing. The result is that Kenya has only 16,000 elephants today versus 140,000 when its government banned hunting. Since 1970, Tanzania's elephant herd has shrunk from 250,000 to 61,000; Uganda's from 20,000 to only 1,600.

Property rights are a less effective solution for environmental problems involving the air, however, because rights to the air cannot be defined and enforced easily. It is hard to imagine, for instance, how market mechanisms alone could prevent depletion of the earth's ozone layer. In such cases economists recognize the likely necessity of a regulatory or governmental solution.

Contractual arrangements can sometimes be used to overcome other public goods and externalities problems. If the research and development activities of one firm benefit other firms in the same industry, these firms may pool their resources and agree to a joint project (antitrust regulations permitting). Each firm will pay part of the cost, and the contributing firms will share the benefits. In this context economists say that the externalities are "internalized."

Contractual arrangements sometimes fail to solve public goods and externalities problems. The costs of bargaining and striking an agreement may be very high. Some parties to the agreement may seek to hold out for a better deal, and the agreement may collapse. In other cases it is simply too costly to contact and deal with all the potential beneficiaries of an agreement. A factory, for instance, might find it impossible to negotiate directly with each affected citizen to decrease pollution.

The imperfections of market solutions to public goods problems must be weighed against the imperfections of government solutions. Governments rely on bureaucracy and have weak incentives to serve consumers. Therefore, they produce inefficiently. Furthermore, politicians may supply public "goods" in a manner to serve their own interests, rather than the interests of the public; examples of wasteful government spending and pork-barrel projects are legion. Government often creates a problem of "forced riders" by compelling persons to support projects they do not desire. Private solutions to public goods problems, when possible, are usually more efficient than governmental solutions.

About the Author

Tyler Cowen is an economics professor at George Mason University and director of the James M. Buchanan Center and of the Mercatus Center.

The cuneiform inscription in the Liberty Fund logo is the earliest-known written appearance of the word "freedom" (amagi), or "liberty." It is taken from a clay document written about 2300 B.C. in the Sumerian city-state of Lagash.